EXECUTIVE INSIGHTS VOLUME XVII, ISSUE 23

Separation Anxiety: Considerations in Frequent Flyer Program Monetization

At the time, the pioneering spin-off (and subsequent IPO) of Affinity Equity Partners in 2014 – have prompted airlines to ’s frequent flyer program (FFP) appeared to usher in revisit the merits of FFP monetization, so long as valued a new era of monetization. In many ways, the customer relationships aren’t jeopardized in the process. creative but radical divestiture of Aeroplan in 2005 provided an While it may not be the best choice for all carrier models, alternative pathway in an industry that was grappling with the strategy deserves careful consideration. escalating factor costs, persistent over-capacity and over-leveraged balance sheets. Despite the initial buzz, however, In this Executive Insights, we examine the strategic rationale, managerial apprehension in the years that followed prevented value maximization strategy and separation dynamics associated widespread adoption of the strategy. with carving out all or part of an airline loyalty program across a continuum of strategic alternatives (see Figure 1). More recent successes – including Virgin Australia’s $293 million, 35% divestiture of its Velocity FFP to Hong Kong-based

Figure 1 Loyalty Program Development

1 2 3 4

Internal Separated Partial spin-off Spin-off program program program program

Fully integrated with Operating as a separate Operating as an Fully divested with only the parent airline for wholly owned independent entity with arms-length linkages to financial and subsidiary of the limited direct airline the parent airline operational purposes parent airline control

Separation Anxiety: Considerations in Frequent Flyer Program Monetization was written by John Thomas and Dan McKone, managing directors, and Brett Catlin, an engagement manager, in L.E.K. Consulting’s Aviation and Travel practice. John, Dan and Brett are based in Boston. For more information, contact [email protected].

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FFP Separation: A Strategic Rationale serve the core airline first instead of migrating to the opportunity with the highest marginal return on invested capital. This second Key benefits arising from a separated FFP typically include: argument is controversial, since it implies that not all decisions are made rationally. There remains, however, the risk that cross • Raising significant funds quickly subsidization can occur between operating units when they are • Driving improved managerial focus jointly managed. The mere potential to obscure underperformance • Creating greater investor transparency in the core airline’s operation could lead skeptical investors to discount a combined entity. The liquidity factor. The ability to raise significant funding is often cited as the primary motive behind loyalty franchise monetization. Early on, these divestitures might have been Ensuring a Successful Separation associated with airlines that were on the verge of insolvency. For airlines, it is important to build a separation architecture that However, recent moves by and to separate does not cede undue control. Unless clear provisions are made in their FFPs without immediately seeking outside capital suggest advance, dividing the program financially and operationally from the “distressed imperative” is not the only factor. the parent company can affect the airline’s ability to promote repeated high-value behaviors among the customer base. Dedicated management. A carved-out loyalty business (“LoyaltyCo”) can attract and harness the energy of a talented As a first step, the organization must examine its prevailing leadership team (often with a different managerial skill set). This policies around the spread (i.e., gross margin on points), float team is exclusively focused on optimizing LoyaltyCo’s stand-alone (i.e., working capital) and breakage (i.e., expired currency) marketing services, capabilities and value, often freeing the associated with the loyalty program. It is also critical to ensure business to grow with fewer constraints. When autonomously that the internal carrying cost of the currency accurately managed, a loyalty program arguably has more license to represents the slate of future liabilities associated with benefit aggressively pursue inorganic expansion. We observe that fulfillment. Even for publicly traded companies subject to IFRIC separated FFPs are also forced by the market to be increasingly 13, the internal mechanism for valuing the nominal “point” is competitive in areas such as CRM, merchandising and promotion. often inadequate when it comes to a separation. In L.E.K.’s They also tend to be more assertive in enlisting a diverse set of experience, determining and validating this metric is a key initial partners capable of enhancing everyday program relevance. activity in a successful separation.

Create greater investor transparency. Another benefit is the Operationally, transitioning from an in-house program to a ability to grant investors greater insight into enterprise financials separated entity must be tightly choreographed to ensure that were not previously shared, understood or appropriately continuity in service delivery. For many organizations the valued. Indeed, the presence of a “conglomerate discount” has question of “who owns the customer relationship” becomes a led various global carriers to divest seemingly symbiotic assets stumbling block when core CRM technology systems are such as technology platforms, maintenance divisions and divided. This conflict can extend to third-party coalition partners regional operations. Observable market multiples for airlines who are integral to the program’s economics (i.e., co-branded versus consumer marketing companies notionally support the providers). The point of delineation is often between assertion that the two distinct business profiles can be worth recognition and accrual/redemption, with the airline owning the more separated than together. The rationale behind this is that former and the loyalty program owning the latter. Regardless of a combined entity, run by traditional airline executives, can bias the ultimate split, it is imperative that a level of real-time data capital decisions to what these executives know best. access (i.e., customer knowledge) and robust communication channels be retained for all parties to the agreement. In other words, “inefficient” economic outcomes can result if cash flows generated by the loyalty program are reinvested to

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Once the financial model has been assessed and the operating Lastly, given the airline’s presence as the anchor tenant to the platform defined, the organization can begin to address a loyalty coalition, the balance of power around accrual and re- broader set of equally important issues to increase the likelihood demption must be thoughtfully designed. This is necessitated by of commercial success post-separation. the imbalance between a proliferation of accrual sources and a relatively fixed supply of “compelling” redemption opportunities. Drawing the Lines for Longevity With redemption demand growing faster than supply, LoyaltyCo might need to pay higher rates in order to maintain the health While the separation of LoyaltyCo from the airline implies of the program. There is also a risk that miles converge to some greater autonomy, the extent of this independence raises a completely transparent standard (say, some factor of a penny number of strategic questions, including: per mile), thereby commoditizing the currency. Preventing this spiral through carefully crafted redemption frameworks is critical • What merger and acquisition alternatives to maintaining the allure, and long-term health, of the program. will be permitted? • What coalition development freedoms Unlocking Liquidity Through Separation will be allowed? • What is the appropriate accrual/redemption Over the past decade, airlines have derived nearly $3 billion framework? in liquidity from partial or full loyalty program separation. The eight transactions that have been completed to date cover a wide The first issue concerns the ability of the separated loyalty entity range of geographies, transaction sizes and airline operating to make acquisitions and divestitures with or without the models (see Figure 2). For the airlines pursuing monetization consent of the airline. For a number of reasons, the possibility in a non-distressed situation, the process generally occurred of capturing value through consolidation will hold some of the over the course of one to two years, with an initial architectural greatest appeal to potential investors. Accordingly, the airline separation forming the base for a subsequent liquidity event. needs to consider how it trades off the potential value of conferring this flexibility with potential conflicts of interest (or For airlines considering partial or full separation of their FFP, conflicts of focus). there are a series of questions that should be addressed to ensure the concept is both financially sound and tactically achievable. The second involves the degrees of freedom that the airline For starters, how much value can be realistically captured from a grants to LoyaltyCo to strike outside partnerships or to pursue separation? While comparable transactions provide a represen- a broader coalition. Clearly, an important activity for customer tative view, each program will have its own distinctive profile. loyalty programs is continued development of this slate of Assuming the “size of the prize” meets internal requirements, partnerships to drive day-to-day program engagement. If management should then perform a more granular interrogation LoyaltyCo is restricted (even partially) from forming value- of the opportunity, including: enhancing partnerships, it may be at a significant disadvantage versus competitors. Questions abound as to where the right Commercial structure: balance is – depending on the number and type of partners • What structures should be put in place to assure any required enlisted – between enhancing, and actually diluting, the loyalty alignment of interests between the airline and the LoyaltyCo? of the airline’s own customers. In the most extreme case, considerations need to be made about what actually defines a • What considerations should be made to accommodate competitor of the airline and how protections can be crafted to changes in accrual structures (e.g., a move to revenue-based prevent LoyaltyCo’s business development engine from directly from distance-based)? or indirectly benefiting players that fall into this set.

• Should minimum levels of activity be contracted?

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Figure 2 Global Frequent Flyer Program Monetization Dynamics

RANK (by amount AIRLINE PROGRAM SPIN-OFF YEAR NUMBER OF AMOUNT RAISED IMPLIED VALUATION raised) MEMBERS * (% of equity sold) (value per member)

2005 -5.0M US$998M US$2.9B 1 (100%)** (US$200 / member)^

2013 -9.3M US$450M US$1.1B 2 (40%) (US$121 / member)

2010 -9.4M US$297M US$1.0B 3 (27%) (US$116 / member)

2014 -4.5M US$293M US$838M 4 (35%) (US$186 / member)

2012 -2.0M US$252M US$30M 5 (70%) (US$180 / member)

2014 -4.0M US$142M US$190M 6 (75%) (US$48 / member)

2013 -2.5M US$150M US$300M 7 (50%) (US$120 / member)

2010 -2.9M US$88M US$180M^^ 8 (49%) (US$62 / member)

Note: *Approximate number of members at time of spin-off; ** While only ~35% of Aeroplan shares were sold through offerings, ~US$2.7B ~US$6.9B ACE gave out shares as dividends and reduced its stake to 0%; ^ At spinoff valuation, ^^ Implied value, 2013 fair value was

US$518M, bought equity at a significant discount

Source: L.E.K. analysis, Bloomberg, company websites, company annual reports

• Will minimum levels of redemption availability be guaranteed? • Will a “golden share” or other similar instruments apply to the spin-off agreement? • How will dynamic redemption mechanisms be calculated? • How long will the airline serve as the anchor tenant to • How will any fees be regulated and which party will benefit LoyaltyCo? (e.g., fuel surcharges, close-in booking fees, etc.)? • How will exclusivity be addressed in the future (e.g., if the • Will any cash, assets and/or liabilities be transferred back to airline wants to launch a new loyalty mechanism for specific the parent entity prior to the spin-off? customers)?

• How will brand(s) and other intangible assets be treated While none of these decisions are straightforward, all can be (e.g., will a licensing fee apply)? resolved through defined approaches; indeed, L.E.K. Consulting has helped numerous airlines and investors with these • What is the process for handling loyalty program partners wide-ranging issues using rigorous bespoke analysis and for which the airline owns the relationship (e.g., other extensive visibility into industry leading practices. airlines, alliance partners, etc.)? Bottom Line Governance considerations: Each airline must balance its broader loyalty strategy to the • How long should the agreement run? maximum benefit of stakeholders with both a short- and long- term view to value creation. While there is no one-size-fits-all • What mechanism should be put in place to protect minority approach, there are ample opportunities for airlines to extract party interests (e.g., related party transaction approval, etc.)? further value from their FFPs.

• What is the resolution process in the case of a merger or other event which fundamentally changes the airline/ LoyaltyCo relationship?

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